Source: Buyouts Magazine
 
Private equity firms last year raised billions of dollars in distress-dedicated capital, readying their war chests for the market’s fall from grace. Now the question is when will they get to use it?
 
At year-end 2005, a number of market observers predicted the market’s downfall to occur in mid-2006 (now), while others seemed surprised that the gutters weren’t already running with red ink. And while things today appear no different than they did one year ago, prognosticators now are casting their lots to next year, or even 2008, to mark the end of the current liquidity cycle.
 
“I don’t understand how we can be in year five of an upswing, have record-tight spreads, twin deficits, geopolitical turmoil, skyrocketing fuel costs, and still be in this robust a marketplace,” says John Dionne, senior managing director at the Blackstone Group and chief investment officer of the firm’s Distressed Securities Advisors arm. “Lots of people thought the market was living on borrowed time a long time ago.”
 
Ironically, one of the things keeping companies out of trouble today are distressed investors themselves. Larry Young, a managing director of AlixPartners’s turnaround and restructuring services practice, says the shortage of traditional distressed opportunities has spurred many of the storm chasers to invest up and down the balance sheets of healthy companies, regardless of security class.
 
“You’ve got distressed investors and hedge funds being a lot more aggressive in new high-yield issuances and private [debt] placements; they’re even getting more involved in equities,” Young observes. “All these guys are being more creative in how they are managing their positions.”
 
This trend, he says, is helpful to companies that have been having trouble, giving them a chance to refinance themselves out of harm’s way, while giving the distressed investors a chance to put their otherwise-idle capital to work.
 
Furthermore, because these lenders are used to taking active roles through the credits they invest, the companies that carry their debt are in a position to benefit from the extra pair of eyes peering into their books.
 
“It’s like a watchdog affect,” Young says, “I’ll get a phone call from someone the moment a company trips a covenant. Three years ago, when companies had a covenant breach or missed a payment and were in default, they filed [for bankruptcy]. Now, because people are involved up and down the capital structure, they are choosing to restructure.”
 
But there is a downside to this financing trend, Young says, which will become apparent when some of these highly levered companies inevitably go sideways. “In bankruptcy situations where multiple lenders hold multiple positions in a capital structure, you’re going to see Debtor A struggling to cram down a Debtor B, and Debtor C is going to want nothing to do with either of them. These types of complicated capital structures create contentious situations,” he says.
 
But when the market will go to pot is anybody’s guess, and some industry pros are growing weary of trying to answer that question. “Every time somebody tries to guess when the market will take a turn, they say, ‘Twelve to 16 months.’ And then when 12 to 16 months pass, things look as robust as they did before,” says Bassem Mansour, co-founder and managing partner of Resilience Capital Partners. “It’s a tiring game.”
 
Most pros point to the high-yield market, which remains strong despite economic pressures, as a way to gauge the strength of the overall market.
 
As of the end of 2005, there was about $800 billion worth of high-yield (junk) bonds in the market, according to Merrill Lynch High Yield Master II. Recently published estimates have pegged the year-to-date issuance at more than $1 trillion. But despite the copious amount of debt currently at work, the global default rate for those bonds—for the trailing 12 months ending May 2006—is about 1.75%, according to Moody’s.
 
The low default rate, says Martin Fridson, publisher of Leverage World, a research service focusing on the high yield market, is likely a residual affect of the higher quality junk issuers in 2001 and 2002, when only about 40% of junk bond issuers were rated B or CCC, while the remaining 60% were rated BB, the highest rating available for high-yield bonds.
 
As of June 15, the percentage of the speculative grade bonds trading at a distressed level—meaning that they have a relative risk of near term default—is about 2.8 percent. For comparison’s sake, in October 2002, the low point in the last economic cycle, 35.5% of junk bonds were trading at distressed levels.
 
To say the least, there is still a lot of ground to cover before the junk market tanks. For the 12 months ending May 2007, Moody’s expects the high yield default rate to rise to about 3%—not exactly what market observers call a tremendous upheaval.
 
“When you start getting into a [default rate] range of about 6% or so, that’s when the spreads are wider and more companies are in distress,” Fridson says, noting that in substantial high-yield fallout situations, default rates historically linger in the double digits, such as 2002’s default peak of 10.8% and 1991’s 12.79 percent.
 
“Default rates tend to be low in the first couple of years after [high-yield] bonds are issued because the company typically has a liquidity cushion, or margin of safety, from the refinancing,” says Michael Weinstock, a managing principal at Quadrangle Group. “But around years three, four or five, the cumulative effect of whatever might be going wrong with the company—be it a macro or micro issue—increases those bonds’ chances of default.”
 
In that light, Weinstock says he expects to see a large number of defaults stemming from the record high-yield issuance of 2003 through 2005.
 
Additionally, some distressed investors are hopeful that the recent flood of second lien financings that hit the market after the last high-yield crash will ensure a bloody future for many companies in the small and middle markets. The second lien market, which has really only developed over the last few years, has catapulted from being a $630 million industry in 2002 to one worth nearly $12 billion as of the close of 2004, according to CIBC World Markets.
 
“There is a significant amount of capital available, which is sustaining businesses and over-leveraged capital structures and delaying traditional balance sheet restructurings,” says Miller Buckfire & Co. Managing Director Marc Puntus. The capital is largely coming from a record number of hedge funds, CLOs (collateralized loan obligations) and CDOs (collateralized debt obligations), which must deploy it in order generate returns for their investors. The abundant liquidity in the market must dry up to some extent before the market will turn.”
 
Of course adding another slug of debt to a company is not a cure-all for every troubled business. But most of the distressed situations in the current marketplace are specific to industry trends, not cyclical events.
 
“The restructurings you’re seeing today are largely linked to distressed industry sectors (e.g., automotive) and businesses impacted by commodity and energy prices, not an overall market downturn,” Puntus holds.
 
Werner Co., a portfolio company of Leonard Green & Partners, is a recent example. The Greenville, Pa. ladder maker—hit hard by skyrocketing aluminum prices—filed for Chapter 11 earlier this month. The company, which manufactures its products primarily in the U.S., tapped the second-lien market for a rescue loan. While that solves the company’s liquidity crunch, there’s still the issue of whether the company will be able to stand up to its competitors that source materials from lower cost countries. As of the end of March, Werner listed assets of $201.04 million and liabilities of $473.45 million.
 
Foamex International Inc. is another company that got dragged down by rising commodity prices. The flexible polyurethane foam producer filed Chapter 11 late last year as part of a restructuring plan that traded debts of $523 million for equity. The company blamed the mounting cost of energy.
 
Anecdotally, market pros say there are signs that the market as a whole is ripe for trouble, and that when this next storm does come, it has the potential to be more devastating than its predecessors.
 
“When I see covenants drying up, loan-only LBOs getting done, and an increasing appetite for risk, that’s a sign that irrationality has entered the market and that a correction will take place,” says Blackstone’s Dionne.
 
AlixPartners’s Young agrees. “Guys are financing air balls,” he says, “you’ve got to worry. People are attempting situations where they will have to triple EBITDA to service obligations, while others—even though they don’t like to admit it—are still out there levering up underperforming companies and waiting for a market change [not operational change] to de-lever the balance sheets. Those will be some of the first situations to get in trouble.”